Year End is a Good Time for Rebalancing (4 Dec 2009)

We are in the month of December now, in the blink of an eye, it seems like the year has passed. The Lehman Brothers crash is now more than one year ago, and while it may not feel like it, most markets have been rising steadily for several months. I remember writing in a column in the Fundsupermart magazine at the start of 2009 that it would be a good year with positive surprises. So far, it hasn’t failed to disappoint. Many markets have shot up 50 to 70% year to date. But now that we have been through two such turbulent years, one with a massive crash, and almost through another with a big recovery, it is a good time to pause and rebalance our portfolios.

What exactly does rebalancing our portfolio mean, why bother to rebalance? The rebalancing method works as follows: Say we start an investment portfolio with $10,000. And as we have often suggested, we spread the investments so that the money is invested in stock markets all over the world. For example, we allocate 35% to US, 30% to Europe, and 35% to Asia. After 1 year, regardless of how well each region performs, we re-allocate our investments so that the percentage of money invested in each region remains the same. So, in a nutshell, rebalancing is about taking profit from your winners and adding money back into your losers on a consistent basis.

We back tested the results over the last 39 years on a $10,000 portfolio using rebalancing every year compared to one that just held throughout with no change. At the end of 29 years, the rebalanced portfolio with 80% into equities and 20% into bond had $176,586 whiel the buy and hold portfolio had $114,731. Hence, the rebalanced portfolio outperformed a buy and hold portfolio while being less volatile.

“Why does this rebalancing method work?” You may ask. It does seem weird because while it looks simple in execution, it requires you to sell off some of your funds that have been giving you the highest returns to invest in funds that might be causing you to lose money.

The clearest example would have been the massive swings in markets we saw from 2007 to 2009. In 2007, stock markets were on a roll, many Asian markets were up 15 to 30%, but bonds were having a flat year. Rebalancing would have resulted in money shifted from the strongest Asian equity funds, moved into bond funds. Then, in 2008, when most equity funds were down 50%, while bond funds were holdings steady, rebalancing would have resulted in money being shifted back from bond funds into equity funds

The whole crux of why rebalancing works, and why we should rebalance, is based on this “that all markets go through its ups and downs, and no single market will be best performing market all the time”. So, the markets that look so bad now, which people are trying to avoid, may eventually have their turn to shine again, and regardless of how hot or good a market looks now, rebalancing forces us to take profit from this market because it believes that such a market will eventually fall from its top spot.

While selling your winners and buying into your losers is tough to do in practice. Another key thing to remember about rebalancing is that it does not require that you sell all of your winning markets or funds. It just requires that you take profit on it. Hence, if one or more markets you selected happen to go through a multi year bull run with very strong performances, you will still benefit from having exposure to such a market. Rebalancing only requires that you take profit occasionally (I usually look to rebalance once a year).

The other part of it, which is to add money to your losing markets is also very hard in practice to do. But again, this method is based on losing markets eventually bouncing back, and the harder they fall, the stronger the eventual rebound would be. Think back again to 2008. The Asian markets fell the hardest compared to other markets like US, Europe, or bonds as a whole. Many Asian markets were down 50% or more. However, rebalancing your portfolio would have meant that you were forced to shift monies from bond funds, US, and Japan into Asia, and your actions would have yielded a handsome return in 2009, with Asian markets rebounding much more strongly than US, Japan or bonds as a whole.

This rebalancing method does not always work so well every single year, like how it did in 2009. (A market could be a strong performer over 2 to 3 years!). However, if practiced consistently over a long period of time, it would do better than just a simple buy and hold method. The reason is because while markets might remain strong, or weak over more than one year, but over a long period of time of ten years or more, then eventually, the strong markets suffer their crashes, and the weak markets get to shine.

In conclusion, as we approach the end of the year, it is a good time to take a good look at your portfolio and rebalance it accordingly. A very simple way could be just to take some profit from your winning investments, and to shift some of that profit into new or existing investments which have underperformed this year. One big caveat though, rebalancing your portfolio works far better with unit trusts and it may work with stocks. The reason being that unit trusts tend to invest into many stocks or bonds and into a broad market. While an entire stock market is likely to go through its cycles of ups and downs, an individual stock could fall flat, never recover or even go bankrupt eventually. Hence, insisting on adding and adding to such a stock will be terrible for your investment returns.